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The Bull Market Has Been Wounded but We Expect Strength Is Around the Corner

  • Since this bull market is almost 10 years old and “information noise” is at sky-high levels through various social/media platforms more than ever before—it is natural to expect rolling concerns at this stage. We think the concerns are healthy to keep in mind the further we travel through the cycle but it may be too premature, at this point, to suggest the cycle is ending and a recession is   around the corner in 2018. Economic growth is still gathering momentum as are corporate profits.
  • The profit cycle remains a cornerstone of the current bull market, and earnings rather than expanding valuation multiples will be paramount in propelling U.S. stocks towards our S&P 500 year-end target of  3000.
  • Volatility is likely to rise as we go through the monetary policy tightening cycle but growth should continue despite this rise because financial conditions remain supportive of economic growth.
  • Within equities, we maintain our emphasis on emerging markets (EM) and U.S. large capitalization stocks given their combination of attractive value and growth.
  • Exposure to small capitalization equities should benefit from less regulation, a solid increase in capital spending (capex), and a rise in domestic economic growth overall.                                                                      
  • In terms of sectors, we maintain our core view that major themes which sustainably expand the long-term profit cycle (think agents of change) in Information Technology, Healthcare, Financials and parts of Industrials are attractive areas to consider buying on weakness.

In bull market environments, market bottoms traditionally take a few months to occur. We believe we are currently in that process. The catalyst that ultimately stabilizes the market and supports higher equity prices is corporate earnings, in our view.  As corporate earnings are announced in the coming weeks, we expect investor flows to once again come back into equities given the high profit growth we anticipate.

Christopher Hyzy, Chief Investment Officer
  • We still believe fixed income remains a good hedge on higher-risk assets such as equities even in a grinding-higher interest rate environment. We prefer higher-quality assets in general at this stage in the cycle.
  • From a longer-term perspective, given the significant rise in stock prices in the last decade, we are likely to experience lower, on average, returns in the next 10 years due to higher starting point valuations and less accommodative central bank policies over time.

Macro Overview

  • The macro backdrop remains positive and supportive of an equity overweight. The synchronized global expansion that began in the first half of 2016 continues to  gather steam, consistent with our outlook for around 4% real gross domestic product (GDP) growth in 2018, the highest pace since 2010.
  • The various stages of the expansion in different parts of the world sort out into an overall global cycle that seems more mid-cycle than late-cycle.
  • In the U.S., consumption should be strong over the rest of the year as consumers receive a boost to disposable income from the recent tax reform. The labor market is as strong as it has been in decades and consumer confidence is approaching an all-time high, while durable goods spending has risen steadily during this cycle, and does not appear to be overextended.
  • The main risks to this macro outlook, in our view, are on the policy front. Announcements of new restrictions on trade policy are likely to cause periodic bouts of market volatility. But we see the tariff measures and counter-measures introduced in the first quarter as insufficient to have a major impact on the fundamental outlook for global growth.
  • We also would not dismiss the possibility that the reset on the way in U.S. trade and foreign policy could potentially have an eventual positive outcome. We believe renegotiating to end unfair trade practices will be a net plus for the U.S. economy just as it was in the 1980s.

Market/ Thematic Strategy

  • Geopolitical risk has been a persistent feature of the current economic expansion and we expect these challenges to continue as we move further into the year. For geopolitical risk to have implications for global markets and risk appetite more broadly, it has historically required an energy supply shock.
  • The mid-term elections also pose a risk but potentially an opportunity. Past mid-term election years have tended to feature policy-related market volatility and large market corrections. Over the past 10 presidential cycles, the S&P 500 has experienced peak-to-trough corrections averaging 15% during the mid-term election year, with a rebound over the next 12 months averaging 28%. Every cycle is of course different, but these historical patterns will be worth keeping in mind over the remainder of 2018 and into next year.
  • We think current federal debt levels are manageable but require close attention on the part of investors. Growing budget deficits (3.5% of GDP in FY2017) and debt held by the public ($14.7 trillion or 76% of GDP) have raised concerns that the government will have fewer resources to stimulate the economy during the next downturn. We think the U.S. government has more fiscal runway and that its finances haven’t approached a tipping point just yet.

Equities

  • Taking a closer look at investment strategy and in particular U.S. equities, our 2018 baseline earnings per share (EPS) forecast remains $153 and our full year EPS range is  $148-$158, supported by continued sales growth, corporate tax cuts, increased stock buybacks, higher consumer spending and an increase in capital spending. With tax cut benefits all but priced into consensus earnings for 2018, the markets could soon start to focus on 2019 EPS where consensus is approximately at $172. Applying a 17.5x forward P/E multiple, which is close to its historical average, to the 2019 consensus EPS of roughly $172 gets us close to our 3,000 target for this year-end.
  • Major technical indicators, such as support zones, breadth, and market leadership suggest further upside for the nine- year bull market.
  • History shows that equities can perform well in a rising interest rate environment. Viewed in the context of periods of rising 10-year Treasury yields, in the 15 distinct periods since 1954, the S&P 500 generated positive performance   in nearly 90% of them, according to BofA Merrill Lynch Global Research.

International

  • Outside the U.S., international developed and emerging markets look particularly attractive on a valuation basis relative to the U.S., with developed and emerging markets alike trading near the lower range of their historic relative bands. Emerging markets are trading at a 12x-13x P/E multiple on 2018 earnings estimates, and Europe is trading at 14x compared to the U.S. at 17x 2018 earnings estimates. In addition, Japanese and European equities operate with lower profit margins as compared to U.S. stocks and offer potential for additional profit growth.
  • Emerging markets have led global equities over the past two years, and have remained relatively resilient in the face of recent trade tensions. We expect the outperformance to persist as we move further into the year.
  • We maintain a preference for emerging Asia overall as the fastest-growing regional market with the strongest balance of payments position, the greatest exposure to improving global trade and the highest weighting in consumer-linked sectors. And we still see support from valuation.

Fixed Income

  • Within fixed income, our expectation is for another two or three quarter-point Fed Fund rate hikes this year, with the 10-year Treasury ending the year in a range of 2-7/8% to 3-3/8%. Low global rates and accommodative European and Japanese central banks should forestall a bigger sell-off in long-term rates, and over time fixed income will play an important role as a diversifier to equities.
  • Given our forecast for the Federal Reserve and Treasury yields, we have been noting for several months that—from this point in the cycle—negative returns in fixed income markets are a possibility. Unfortunately, for now, this seems to be the case. However, the longer an investor continues to hold fixed income instruments, the more income may come to dominate total returns and price moves would be less relevant. Stay the course.
  • High yield credit remains underweight in our tactical asset allocation framework for fixed income. Exposure to lower- quality credit at this point in the economic cycle should be below benchmark (negative view) due to our belief that the yield pickup is not wide enough to make up for the given level of risk.
  • This year the London Inter-bank Offered Rate (LIBOR) has risen steadily and sharply, but we do not think this is highlighting any systemic market funding issues. Other short- term market rates are also significantly higher year-to-date, and more direct measures of bank credit risk—credit spreads and credit default swaps—have not moved nearly as much as LIBOR. Instead, it seems that two factors together are putting pressure on short-term markets: U.S. firms bringing back cash from abroad due to a tax law change, and an increase in Treasury bill issuance by the U.S. Treasury.

Municipals

  • Historically, municipal bonds have exhibited very low credit risk. However, a game changer in muni credit since the financial crisis has been the mushrooming of unfunded pension and other post-employment benefit (OPEB) liabilities. We believe that for most muni issuers, pension problems are manageable, and can be improved over time.
  • While municipal default rates have ticked up since 2008, they are still relatively isolated events. Muni default rates remain lower than corporate default rates, and we continue to believe that widespread defaults due to pension liabilities are unlikely.

Alternative Investments

  • With volatility squarely back in focus, we expect that allocations to hedge funds will become increasingly important to multi-asset portfolios and recommend qualified investors consider looking to the asset class as a way to help manage risk and return potential in the current environment. Within hedge funds, we currently favor allocations to equity long/short and equity market neutral strategies.
  • Given the increasing need for infrastructure development and/or replacement (at home and abroad), plus the less-than- optimal fiscal condition of many states/municipalities, we think we will see an increasing amount of private infrastructure transactions in the coming years. We believe private equity infrastructure can be a compelling satellite position within a diversified private equity portfolio for qualified investors with longer investment horizons to consider.

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